Goldman defector draws attention to electronic trading firms
When Sergey Aleynikov was busted, he was headed to work for Teza Technologies.
NEW YORK (Fortune) -- After the arrest earlier this month of Sergey Aleynikov, the former Goldman Sachs IT executive, the blogosphere was briefly abuzz with the notion that Aleynikov's new employer would be the Chicago-based, Global Electronic Trading Company, known as GETCO. GETCO is far from a household name, and so the rumor and Aleynikov's arrest drew attention to the highly secretive corner of Wall Street firms, such as GETCO, that are big players in the world of electronic trading.
As it turned out, Aleynikov actually had accepted an offer to work for a GETCO competitor, Teza Technologies. That was before he was arrested at Liberty International Airport in Newark, N.J. on July 3. Federal prosecutors subsequently charged Aleynikov with allegedly stealing some proprietary technology that allows Goldman Sachs to execute high-speed and high-volume trades.
At a July 4 court appearance, Sabrina Shroff, a lawyer for Aleynikov, said that the government's allegations were "preposterous." She claimed her client was downloading programs to his personal computer to work at home and hasn't disseminated the code.
The reason that trade secrets are so highly coveted in this world is that firms like Teza and GETCO use their own money to exploit tiny discrepancies in the price of securities from one millisecond to the next. When it comes to computer-driven mega trades, milliseconds count.
For instance, a typical trading strategy for GETCO and its ilk would be to exploit the momentary pricing differences between a stock index -- say the S&P 500 (SPX) -- and the stocks that comprise that index. It's a new form of arbitrage that relies primarily on proprietary computer programs, high-speed computers in huge data centers and proximity to various exchanges to be able to get the proprietary information before competitors via high-speed fiber optics cables.
"Electronic routing and execution has become the mechanism by which our capital markets operate," according to a recent report by Robert Iati, a partner at TABB Group. "Algorithms account for more than 25% of all shares traded by the buy side today -- a number steadily rising for several years now." Iati said that the "incredible capabilities" offered by technology have given meteoric rise to a relatively few high frequency proprietary trading firms, and that familiar names like "Merrill [Lynch] are being replaced by less familiar ones like Wolverine, IMC and Getco."
In an interview with Fortune, Iati recounted how these proprietary trading companies are vying to locate as close to the New York Stock Exchange's new multi-million-dollar data center -- being built in Mahwah, N.J. and set to open in 2010 -- as they can to get the information about trading activity as quickly as possible. "Proximity is everything now," he said, since the data travels over fiber-optic cables at light speed and the less distance it travels, the more quickly it arrives, and the more quickly the price discrepancies can be exploited.
GETCO was founded in 1999 by former traders Daniel Tierney and Stephen Schuler, and Schuler's wife, Mary Jo Schuler, in Chicago -- where many of the new breed of millisecond trading operations are based so as to be close to the Chicago options and trading exchanges. Sophie Sohn, a spokeswoman for GETCO, declined to make additional information about the company available, such as the founders' background, where they used to trade, or the firm's revenues and profits. Sohn said Schuler was out of the country on vacation and would not be available to comment about his firm's business.
What is known is that the Schulers, who have two children, are prominent philanthropists in Chicago, having started the Good Heart Work Smart Foundation, which donated some $200,000 to the Park District of Oak Park to renovate a Chicago park. And according to Iati, at the TABB Group, GETCO is making "hundreds of millions of dollars" in annual profits these days and employs "several hundred people," 200 to be exact, according to Sohn, who work in Chicago, New York, London and Singapore.
Iati said firms such as GETCO are "very prominent now and wield a lot of influence" in part because they are providing badly needed trading liquidity to the market at a time when the traditional sources of that liquidity -- the big investment banks -- are extinct or highly regulated.
In April 2007, General Atlantic Partners, which refers to itself as a "global growth equity" investor, bought a minority investment in GETCO that, according to The Wall Street Journal, was between $200 million and $300 million, and that valued the firm at between $1 billion and $1.5 billion. General Atlantic CEO Bill Ford, and his partner Rene Kern joined the GETCO board, although no other information about the company or General Atlantic's investment in it is available on the General Atlantic website. A spokeswoman for General Atlantic said both Ford and Kern were traveling and not available to comment. She also declined to confirm the amount of General Atlantic's original investment in GETCO.
"We are partnering with General Atlantic because of our shared vision for the evolution of capital markets, the firm's understanding of the impact of technology on financial services, its experience supporting growth companies in our industry and its extensive global network," Schuler said at the time.
Iati said he believes General Atlantic has "made a mint" on its GETCO investment. A spokeswoman for General Atlantic said it would not be unusual for GETCO to at some point consider a public offering although no such IPO was currently in the works.
GETCO also has a separate business from its proprietary speed-of-light arbitrage business that provides customers, such as money managers and hedge funds, with fast-trade execution often with an "immediate or cancel" feature that insure that the trades cannot be traced. These hidden stock-trading venues, also known as "dark pools" -- in part because the trading takes place away from any exchange and therefore without any reports being filed -- have captured an increasingly large share of U.S. equity volume in recent years.
The leading "dark pool" is Goldman Sachs' "Sigma X," which executed about 162 million external orders in April 2008 followed by CrossFinder (owned by Credit Suisse), Knight Link (owned by Knight Capital Group) and then by GETCO, which started its GETCO Execution Services dark pool in March 2008, also according to TABB Group.
As for Aleynikov, his new firm, Teza placed him on leave after his arrest. And the Goldman Sachs (GS, Fortune 500) defector is not Teza's first brush with controversy. Teza is an "offshoot" of Citadel (the Chicago-based mega hedge-fund). However, following Aleynikov's arrest, Citadel sued several Teza employees including former Citadel trader Misha Malyshev and two other former Citadel employees, alleging that their formation of a new trading firm violated a non-compete agreement they had with the hedge fund.
The complaint, filed July 9 in the Chancery Division of Cook County Circuit Court, named Teza, Malyshev and his colleagues Jace Kohlmeier and Matthew Hinerfeld, who both left Citadel along with Malyshev earlier this year. It asks the court for an expedited hearing in the case, saying that Teza could cause "irreparable" harm to Citadel. It also mentions the Aleynikov affair, saying, "Teza's decision to hire Aleynikov, an accused software thief, creates a substantial risk that they have stolen, or may be planning to steal, Citadel's proprietary code."